FARO Technologies Inc (FARO) 2010 Q4 法說會逐字稿

Good morning, everyone, and welcome to Faro Technologies' conference call in conjunction with its fourth quarter 2010 earnings release. At this time, all participants are in a listen-only mode. Later, there will be an opportunity to ask questions. You can enter the question queue at any time during the conference by pressing star, one. Please note that this conference is being recorded.

For opening remarks and introductions, I will now turn the call over to Vic Allgeier. Please go ahead.

Thank you, and good morning, everyone. My name is Vic Allgeier, the TTC Group, Faro's investor relations firm. Yesterday, after the market closed, Faro released its fourth quarter results. By now, you should have received a copy of the press release.

If you have not received a release, please call Nancy Setteducati at 407-333-9911. The press release is also available on Faro's website at www.Faro.com.

Representing the Company today are Jay Freeland, President and Chief Executive Officer, and Keith Bair, Senior Vice President and Chief Financial Officer. Keith and Jay will deliver prepared remarks first and will then be available for questions.

I would like to remind you that in order to help you understand the Company and its results, management may make some forward-looking statements during the course of this call. These statements can be identified by words such as we expect, we believe, we predict, we target, our growth targets, our goals, our guidance and similar words. It is possible that the Company's actual results may differ materially from those projected in these forward-looking statements. Important factors that may cause actual results to differ materially are the risk factors set forth in yesterday's press release and in the Company's filings with the SEC.

I'll now turn the call over to Keith.

Thank you, Vic, and good morning, everyone. Sales in the fourth quarter of 2010 were $58.5 million, a 27.1% increase from $46 million in the fourth quarter of 2009. That brought our 2010 annual sales to $191.8 million, a 29.9% increase from $147.7 million in 2009.

On a regional basis, fourth quarter sales in 2010 in the Americas increased 34.3% to $22.3 million, compared to $16.6 million in the fourth quarter of 2009. Sales increased 14.9% in Europe to $23.9 million from $20.8 million in the fourth quarter of 2009. Sales in the Asia-Pacific region increased 43% to $12.3 million from $8.6 million in the fourth quarter of 2009.

The effect of changes in foreign exchange rates on sales was a decrease of $1.6 million in the fourth quarter of 2010. Comparing year-over-year growth, 2010 sales in the Americas increased 31.4% to $72.4 million from $55 million in 2009. Europe's sales for 2010 increased 18.7% to $74.7 million from $63 million in 2009. And Asia sales increased 50.5% in 2010 to $44.7 million from $29.7 million in 2009.

The effect of changes in foreign exchange rates on sales was a decrease of $2.8 million in fiscal 2010. New orders increased 26.9% in the fourth quarter of 2010 to approximately $67.4 million, compared to approximately $53.1 million in the fourth quarter of 2009. On an annual basis, new orders increased 30.5% to $197.9 million in 2010 from $151.7 million in 2009.

On a regional basis, fourth quarter orders in 2010 in the Americas increased 34.4% to $25 million, compared to $18.6 million in the fourth quarter of 2009. Orders increased 12.9% in Europe to $28.1 million from $24.9 million in the fourth quarter of 2009. Orders in the Asia-Pacific region increased 49% to $14.3 million, compared to $9.6 million in the year-ago quarter.

Again, comparing year-over-year orders growth, new orders in the Americas increased 36.4% to $75.3 million in 2010, from $55.2 million in 2009. Orders increased 15.3% in Europe to $76.7 million in 2010, compared to $66.5 million in 2009. Orders increased by 53% in Asia in 2010 to $45.9 million, from $30 million in 2009.

The top five customers by sales volume in 2010 were the US military, Airbus, General Electric, Daimler and Lockheed Martin, and represented only 4% of our sales. The top 10 customers in 2010 represented only 5.4% of our sales, once again indicating our lack of dependence on any one or a handful of customers.

Gross margin increased in both the fourth quarter of 2010 and fiscal 2010, primarily as a result of the change in the sales mix between higher margin product sales and lower margin service revenue, resulting from an increase in product sales. Our gross margin was 59% in the fourth quarter of 2010, compared to 55.4% in the year-ago quarter.

Gross margin from product sales increased to 64.1% in the fourth quarter of 2010 from 59.3% in the fourth quarter of 2009, primarily due to an increase in product sales mix of higher margin product lines. Gross margin from service revenue declined to 31.5% from 35.6% in the fourth quarter of 2009 primarily due to an increase in customer service costs.

Gross margin in fiscal 2010 was 59.1% compared to 54.6% in fiscal 2009. Gross margin from product sales increased to 65.3% in fiscal 2010 from 60.7% in fiscal 2009, primarily due to an increase in the product sales mix of higher margin product lines.

Gross margin from service revenue remained relatively flat at 30.9% in fiscal 2010, compared to 31% in fiscal 2009. Selling expenses were 26.8% of sales in the fourth quarter of 2010 compared to 26.4% in the year-ago quarter. Selling expenses increased to $15.7 million in the fourth quarter 2010 from $12.2 million in the fourth quarter of 2009, primarily as a result of an increase in compensation of $2.2 million, marketing and advertising expenses of $600,000 and travel expenses of $200,000.

In fiscal 2010 selling expenses decreased to 26.4% of sales, compared to 32.9% in fiscal 2009. Administrative expenses in the fourth quarter of 2010 were 12.5% of sales, compared to 13.8% in the fourth quarter of 2009, increasing by $900,000 to $7.3 million from $6.4 million in 2009, primarily as a result of an increase in compensation costs of $1 million, including $700,000 related to an increase in performance-based bonuses.

In fiscal 2010 general and administrative expenses were $26.8 million or 14% of sales, compared to $24.9 million or 16.9% of sales in fiscal 2009. Fiscal 2010 expenses increased primarily due to the $1.1 million costs of the FCPA monitor in connection with the DOJ and SEC settlement, an increase in legal and professional fees related to patent litigation of $800,000 and an increase in performance-based bonuses of $1.1 million, offset by a decrease in compensation costs of $900,000 due to reduced head count.

Research and development expenses increased to $3.9 million for the fourth quarter of 2010 or 6.6% of sales, compared to $3 million or 6.6% of sales in the fourth quarter of 2009.

R&D expenses for fiscal 2010 increased $100,000 to $12.7 million for the year ended December 31, 2010 from $12.6 million for the year ended December 31, 2009, primarily due to an increase in performance-based bonuses of $800,000, offset by decreases in materials of $100,000 and subcontractor expenses of $600,000.

Research and development expenses as a percentage of sales decreased to 6.6% for the year ended December 31, 2010 from 8.5% for the year ended December 31, 2009.

Operating margin for the fourth quarter of 2010 was 10.6%, compared to 5.4% in the year-ago quarter as a result of the previously mentioned increase in gross margin and decreases in selling and administrative expenses as a percentage of sales. Operating margin for fiscal 2010 was 8.8%, compared to a negative 7.4% in fiscal 2009.

Other income expenses changed to an expense of $964,000 in the fourth quarter 2010, compared to income of $256,000 in the fourth quarter of 2009, primarily as a result of an increase in foreign currency losses related to the effects of the decline in the euro on the value of inter-company account balances denominated in different currencies with the Company's European subsidiaries.

On a year-to-date basis, other income and expense changed to an expense of $2.7 million in fiscal 2010, compared to income of $831,000 in fiscal 2009, again, primarily as a result of an increase in foreign currency losses related to the effects of the decline in the euro on the value of the inter-company account balances denominated in different currencies with the Company's European subsidiaries.

Income tax expense was $377,000 for the fourth quarter 2010, compared to $3.3 million in the fourth quarter of 2009. The effective income tax rate was 7.2% in the fourth quarter of 2010 and includes a release of evaluation allowance of approximately $1.2 million related to net operating losses of a subsidiary in Germany as the result of being included in a group consolidated tax filing with net taxable earnings.

Income tax expense in the fourth quarter 2009 included $2.6 million related to a settlement with the IRS of audit of the Company's federal corporate income tax returns for the periods 2005 through 2007. Income tax expense increased to $3.1 million for fiscal 2010, compared to $424,000 in fiscal 2009 primarily as a result of an increase in pre-tax income.

The Company's effective tax rate for fiscal 2010 was 22.1%. Excluding the effects of the $2.6 million tax settlement in order to provide a better basis for comparison, the Company's effective tax rate would have been 21.7% for fiscal 2009. The tax settlement will not impact the Company's tax rate going forward.

Net income was $4.8 million or $0.29 per share in the fourth quarter of 2010, compared to a net loss of $621,000 or $0.04 per share in the fourth quarter of 2009. Net income for fiscal 2010 was $11.1 million or $0.68 per share, compared to a net loss of $10.6 million or $0.66 per share in fiscal 2009.

I will now briefly discuss a few balance sheet and cash flow items. Cash and short-term investments were $115.7 million at December 31, 2010, compared to $100.1 million at December 31, 2009. Accounts receivable was $51.9 million at December 31, 2010, compared to $42.9 million at December 31, 2009. Day sales outstanding at December 31, 2010 decreased to 81 days, from 85 days at December 31, 2009.

Inventories increased to $42 million at December 31, 2010 from $38.7 million at December 31, 2009. The increase in inventories was primarily related to an increase in raw materials related to the introduction and manufacturing of new products.

Finally, I'll conclude with some statistics regarding our headcount numbers. We had 781 employees at December 31, 2010, compared to 734 at December 31, 2009, an increase of 47 employees or 6.4%. Account manager headcount at December 31 was 147, with 43 account managers in the Americas, 50 account managers in Europe and 54 account managers in Asia. Geographically, we now have 311 employees in the Americas, 262 employees in Europe and 208 employees in the Asia-Pacific region.

I will now hand the call over to Jay.

Thanks, Keith. Well, what a difference a year makes. After successfully navigating the treacherous waters of 2009, we found our footing again in 2010, growing 30% and positioning ourselves well for 2011.

There was a lot to be excited about last year. Strong sales, good operating leverage from the tough decisions we made in 2009, exceptional customer service and breakthrough introductions of disruptive technology. The Faro team responded well to the challenge and our customers responded by continuing to choose Faro as their 3D measurement and imaging supplier of choice.

Asia had a particularly strong year, growing orders 49% in the fourth quarter and 53% for the year. All our Asian countries were strong, including Japan, China and India, our biggest markets. We also continue to expand our presence in Asia, adding additional sales people in every country, as well as opening a direct office in Korea to complement our distribution presence already on the ground.

The Americas also had a strong year, growing orders 34% in the fourth quarter and 36% for the year. In the fourth quarter of 2009 we started to see signs of life again in the Americas, and in 2010 we saw a return to normal buying patterns and behaviors. Customers are consistently looking for new ways to achieve productivity in their plants and processes and Faro solutions are a perfect match.

Within the Americas, we've been successful in Brazil for about 10 years using a distributor. Capitalizing on that success, we have now opened a direct sales and service office in Sao Paolo. We continue to see tremendous opportunity in Brazil due to its manufacturing base and the economic growth. The grand opening of the new Faro do Brazil facility went extremely well and customer response has been strong.

Europe in 2010 had good growth, growing orders 13% in the fourth quarter and 15% for the year. On a euro basis, growth would have been in the mid-20s, so obviously, exchange rates had a bit of an impact there. We expect Europe to be stronger in 2011 and the team there is already implementing additional marketing and sales strategies to improve our growth this year.

For the year, sales to new customers totaled approximately 40% of sales, while sales to existing customers represented approximately 60% of our volume. This is similar to what we saw in 2009.

As many of you know, we have strategically been pushing to keep this ratio at about 50-50 in order to continue populating the untouched opportunity in our space. Not surprisingly, our existing customers, who already understand the benefits of our technology, were the first to start purchasing as economic conditions improved, and that trend continued throughout 2010.

This does not at all change our view of the opportunity in the markets that we serve. We still believe we are approximately 5% penetrated of the total available market. We'll continue pushing to return the ratio of new customer to existing customer sales to 50-50, but it may take another year or two to get it there.

One of the best strategic moves we made during the 2009 downturn was to maintain our R&D spending. We could see the promise and potential of the new products we had in the development pipeline and felt we could accelerate our competitive advantage by keeping them on track.

The result of that decision was the release of two extremely exciting products in 2010, with more on the way in 2011. The first to be released last year was the Faro AMP, our high-accuracy, non-contact 3D imaging product. This is a brand-new solution for us, stemming from the acquisition of patent rights from an MIT spinoff almost three years ago.

The AMP, in its current form, is disruptive for a combination of three reasons -- its accuracy of approximately 25 microns, capture speed of approximately 10 seconds and overall price point of approximately $85,000. This device will be sold through our existing channel and will be sold to our existing customer base, where the need for this type of product is real and exists today.

However, I'll also reiterate that this is a first-generation product and will not contribute substantially to our sales in the next year or two. We expect that the next generations will leverage the work we've already done to further enhance the disruptive potential of this product.

In October of last year we introduced the Faro Focus, our latest long-range 3D scanning and imaging device. As I mentioned before, the Focus was an extremely disruptive product release. Five times smaller, four times lighter, featuring an integrated touch screen which allows operation without a laptop, integrated color, a basic camera tripod, portability in a backpack and a 60% reduction in price. All of that with no loss in performance for the customer and the same high gross margins we've come to expect as a Company.

There isn't a product on the market that can compete with the new Focus laser scanner. As should be the case from a highly disruptive product, sales of this device exceeded our expectations in the fourth quarter. We sold more Focus laser scanners in the fourth quarter than we did in the entire fiscal year for any of the previous generation laser scanners. Customer response has been extremely positive.

The new Focus has also opened up an entire new vertical for us -- the construction and surveying space. Most of our initial sales have been to distributors in that space who are coming to us asking to rep the product in their territory. Several of those distributors have already sold out of their initial batch order and have placed orders for their next batch of product.

We expect sales of the Focus 3D to become a significant contributor to our results beginning in 2011 and, as I have often stated before, it's possible that over time the laser scanner could be our highest-selling product by a substantial amount.

Not surprisingly, we haven't stopped there. The next generation laser scanner development is under way, and though I don't suspect you'll see a new generation in 2011, we are on the path towards driving this product to where it really needs to be -- under $10,000 of selling price and even greater enhancements to the ease of use.

In 2011 you'll see a few other new products with disruptive potential. Some of you may have already seen the sneak preview of our next generation ARM on the TV show American Choppers a few weeks ago. Also coming soon are releases of the next generations of our other core products, also disruptive in their own right.

In short, our decision to stay the course with R&D in 2009 is beginning to pay significant dividends for Faro.

Finally, I'll wrap up by touching on a few miscellaneous items. First, I'll provide a short update regarding the monitor assigned to us by the DOJ in connection with our FCPA settlement in 2007.

The monitor completed her first review of Faro during the third quarter. We are working with the monitor to implement recommendations from a report, but we are pleased with the results of her initial review.

Under the terms of our agreement with the DOJ, there should be one more review in 2011, most likely in the third quarter. Last year's review cost close to $1 million. We expect this year's review will be less than that. Assuming the next review goes well, that should conclude this matter.

Second, I'll discuss the patent suit with Nikon. We have an ongoing patent suit which was brought against us by a former competitor named Metris, who is now owned by Nikon. The suit claims we infringed their laser line probe, a non-contact device that is placed on an ARM.

In response we have filed counter-claims, in particular for inequitable conduct in the prosecution of the patent itself. Our case on inequitable conduct was actually heard first and we expect the judge to rule shortly. In the meantime, we attempted to settle again, with the assistance of a mediator. However, we considered the other party's demands to be both unrealistic and completely unacceptable. We strongly believe that we don't infringe the patents in question. As a result, we believe it is still much better for Faro and our shareholders that we continue fighting this matter.

Last, the Company remains in extremely good financial condition. Many investors have asked if the cash on the balance sheet, now at $115 million, is still targeted at acquisitions. The short answer is, yes. We continue to look actively. At the same time, I still haven't seen anything that is worth our investment.

I'm confident that we will find an appropriate use for the cash, which will generate substantial return for the Company and our shareholders. However, I'm not putting a timeline on that. Finding the right type of disruptive technology is not an easy thing. We'll find the right type, and when we do, we'll move quickly and efficiently, as we have done in each of our previous acquisitions.

Similar to our practice in 2009 and 2010, we are not issuing specific guidance for 2011. However, and as I stated in last night's earnings release, we maintain the view that our markets remain highly underpenetrated, and we believe we have the ongoing opportunity to achieve the annual 20% to 25% sales growth rates we have historically achieved.

In closing, I'd like to thank the Faro team, our customers and our investors. 2010 was a great year. We returned to our historical growth rates, introduced innovative new products and operated a lean and efficient Company. I am optimistic for 2011 and look forward to updating you again at the end of the first quarter.

I appreciate your attention, and I'll now open the call to questions.

(Operator instructions). We will go first to the site of Mark Jordan with Noble Financial. Please go ahead, your line is open.

Thank you. Good morning, Keith and Jay. Question on the marketing expense. It actually increased as a percent of revenue sequentially with the strong results. Should you not achieve some operational leverage in this area as sales increase, number one. Number two, you obviously had a large number of orders that were not able to be fulfilled and carried backlog over. Are there any commissions related to that that were paid for product to be delivered early next year? Finally, where do you think selling expense as a percent of revenue can move over time?

Yes, good morning, Mark. So on the marketing side, I think probably the sequential uptick that you see there is tied to the launch of the Focus 3D. We are getting leverage on the marketing side. However, given the importance of the launch to us and doing it the right way, we did make some conscious decisions to put some extra effort into the launch, to make sure that that product took off the right way, so that's what you're seeing there.

There are not any commissions in the selling expense line related to the backlog. We do not pay until the product ships. So you're right -- we have a very nice backlog going into Q1 here, which is a good thing. We do not pay the commission to the account manager until the product ships out the door to the customer and when we book revenue.

Then finally, where can sales and marketing costs go over time? Our historical target has been to keep it right in sort of that 25% range. As you know, we've been as high as 30%, 31% in previous years, setting aside '09. Even in '08, I think we were as high as maybe 30%, 31%.

So we are getting good leverage there. Given that we still have a fairly missionary sales process, 25% is probably the right spot. And even with the Focus and the success we're having there, which obviously is not going through our account managers almost at all -- we have account managers who are still selling the product into the vertical that we know well, and that will be effective for sure. But in this construction and surveying space, where we're going to be selling through distributors, the reality is that we are probably going to still be looking at 20%, 25% types of commissions to the distributor to keep them interested in moving the product. So I still think that's, over time, the right number to be targeting.

G&A expense, you mentioned a significant bonus expense that was reported in the fourth quarter. Should that imply that you upped that expense as you had the strong end to the year, and that a normalized run rate in the fourth quarter for G&A would be about $400,000 lower than the actual?

Right. Hey, Mark, it's Keith. The bonus for the fourth -- well, first of all, there were no bonuses in 2009 at all. The fourth quarter represents -- you're right, it's sort of a true-up based upon how much profits we've achieved in the fourth quarter, relative to our plan for the entire year. So as the profits were up, the accrual for the bonuses were up as well.

And you're right -- on an ongoing basis we anticipate, 2011, achieving our targets and accruing for a bonus throughout every quarter in fiscal 2011.

Okay. Relative to the tax rate, it looks like if you added back the valuation reserve that was released you would have been around a 30% tax rate for the year. Commentary as to what you think that might be in 2011?

Yes, I think that you're right, that's probably a good rate. I'd say 30% to 32%, maybe, for 2011.

Okay. Then a final question if I may -- the headcount actually tapered down a little bit in the fourth quarter versus the third. Jay, you've talked about keeping that under control -- growth under control. With the improvement, do you think that you'll be growing the sales rep base in 2011, and what kind of percentage growth rate might you assume?

Yes, we certainly feel like we're getting leverage out of that team, number one, so you're correct there. I do anticipate adding account managers in 2011. Because it's a missionary sales process, we do still have that constraint on how many demos can be done in a month by a particular individual. So we do expect adding more people this year.

I won't put a specific number on it. I will say that the expected increase would be substantially lower than the actual sales growth increase for the year. There will be some balancing that goes there.

So if sales grew, for example, 25%, you would not expect the sales force to grow 25%. You'd expect something substantially below that.

Okay, thank you very much.

Thanks, Mark.

Thanks, Mark.

We will go next to the site of Jim Ricchiuti with Needham and Company. Please go ahead, your line is open.

Hi, thank you. Just a question on Focus. Jay, I wonder if there's a way, if you were to break out the revenues or orders from the construction survey market and talk a little bit about the business ex that in terms of the comparison versus the previous product. How is it doing in the markets that you have been already addressing?

Yes, it's obviously a little bit harder to tell, because it is such a dramatically different product. What I'd say is that it is equally good in the other markets that we were selling to already. And again, some of that you need to look at, and it was the first quarter out of the gate. So you've got account managers selling there, and so you're back to the constraint on how many demos can those account managers do and sell the product, albeit I'd say that their success rate was starting to show signs of improvement just because it is a far better product.

So going forward I expect the core markets where we were already selling certainly would continue to improve as the account managers address those. And then yes, the construction and survey space, which is sort of on its own because we will not add account managers to sell into that space, we will rely on the distributors -- because the reality is all those companies that are ultimately receiving the product already buy through that distribution network. There's no need for us to try and replicate that.

We do see a substantial opportunity, and probably would be a much higher growth opportunity in the near term because you already have that established channel that we can push the product through.

Do you see expanding that channel significantly just as you've gotten traction in the construction survey market? Do you plan to add more distributors over the next one to two quarters?

For sure. I think you'll see us adding distributors throughout the year. There are a lot of distributors that are out there, and we do not do exclusivity. We go after -- for sure we want the best distributors, and so as they come to us we make analysis on what markets they can touch, what territories they currently touch, what's been their success historically, things like that.

But I think you would expect to see us adding distributors probably throughout the year, not just for the first couple of quarters.

Can you say how many you had at the end of the year, Jay, in this market?

I cannot. We haven't decided if that's something we will disclose going forward or not. Give us a quarter or two, Mark. And I understand the drive there, because similar to knowing how many account managers we have and being able to determine kind of a run rate you'd expect off the account managers, I'm sure you guys want to be able to do the same sort of thing out of distributors.

We will look at it and determine if we think that would be an effective thing to give any ranges on, but we need a couple of quarters.

Okay. Just in distribution overall, I guess it's been running at about, what, 5% of revenues of so? What was it in 2010, and maybe is there any color you can give us in terms of Q4?

I don't know if we've ever disclosed exactly what it is other than, you're right, we've said historically it's about 5%. Because the model historically was that we only used distributors in spots where we didn't have account managers yet, but thought there was an interesting market to at least test the waters on.

I would certainly argue that on an orders basis, obviously, shipment basis, it would be a little bit lower. On an orders -- lower than what I say -- on an orders basis it certainly would have increased in the fourth quarter, though I don't think you would say geez, did it double up or triple up. I don't know if I would say that at this point.

That's probably about as far as we would go, again, given that we don't disclose revenue by product line. We're trying to avoid if people see the size of the distribution revenue they're going to assume that a good chunk of that is through the LS and may give away more than I really want to from a competitive market standpoint.

Okay, and Keith, just a question for you. I may have missed it, but did you say that the monitor costs, I think you said, were $1.1 million. Is that right, and how much of that was in Q4?

Yes, for the year it was roughly $1.1 million. I think in Q4 it was a little over -- it was, like, $200,000 to $300,000 in Q4.

That's not just the cost of the monitor itself. There's some other legal costs from our side --

There's some other of our outside legal firm, too.

Got it. Then on the litigation costs, that $800,000 was for the year?

I think -- let me just confirm that number. Yes, that was the increase for the year.

That was the increase for the year.

Right.

Okay. Can you give us a rough idea of how much it was in litigation costs in Q4?

Q4 was about $400,000.

Okay. Then last question, just as it relates to how we should think about monitor costs next year. You gave us some -- it's going to be less in 2011, but is it more back-end loaded? Is it Q3? I'm just trying to get a sense as to where it might hit you. It doesn't sound like it's going to be a big number, though.

Yes, odds are the bulk would hit in Q3, and again, that's only because that's our estimate of when we believe the monitor would return. She has not given us a firm date yet, though. In our dialogue with her she's been pretty open about the fact that that's probably the most logical time to come back.

Okay. Thanks very much. Congrats on the quarter.

Thanks, Jim.

(Operator instructions). We will go now to the site of Ajit Pai with Stifel Nicolaus. Please go ahead, your line is open.

Yes, good morning, and congratulations on a very solid quarter.

Thanks, Ajit.

Thanks, Ajit.

A couple of quick questions. I think the first is just looking at your distribution strategy. I know you mentioned you didn't want to give us color as to how much is going through indirect for us to be able to gauge or your competitors to be able to gauge what your product mix is. But just in terms of understanding the channel strategy slightly better, especially you mentioned Brazil, you talked about having distribution there, then you talked about setting up an office there. Could you give us some idea as to how you're managing the channel conflict, and depending on the mix of distribution relative to your wholly owned, what the implications on the margins are going forward?

Yes, I'll let Keith talk to the margins, I'll talk about the strategy for a second, and it's a good question. I want to make sure that -- that probably wasn't as clear. So in Brazil, just to use that as an example, we historically had a distributor there.

We actually -- or a rep there. We actually picked up the employee base of that rep, brought it in, made them Faro employees and then we are supplementing that as well. So that actually will still be -- there won't be a conflict with a distributor on the core products in Brazil in that regard.

In Korea, we actually are going to continue to have the distributor and our own office, and it's sort of the distributor covers the northern part of South Korea and our office, for the time, will cover the southern part of South Korea. So that's how we avoid the conflict there.

For the rest of the distribution, which tends to be tied to either -- they're in countries where we don't have a presence today, so there's no conflict, or all the distributors that we're signing up on the laser scanner, the ones on the laser scanner side, because they are so uniquely focused on that construction and surveying space, again, that's how we avoid conflict there, that our account managers will be selling to other verticals. The distributors will be selling into construction and survey, and yes, you may occasionally see one of our account managers have a tie to the construction or surveying side, but for the most part they will be almost completely separate. So that's how we keep the potential conflicts to a very, very low minimum.

On the commission side, typically the distributors are getting a discount of roughly 20% to 30%, so to the extent that that affects the gross margin compared to a direct salesperson who the commission is roughly 12%, plus you're paying fringes and you're paying for travel and all that sort of thing, and that's going to fall out in the operating margin. So that's pretty much the geography of the income statement where those items actually hit.

Sorry, can you just go over the gross margin implication again?

Yes, the discount for a distributor would be anywhere from 20% to 30% off list.

Got it.

And that would hit the gross margin line.

That would hit the gross margin.

That would hit the gross margin, but on the operating margin side it's fairly neutral because you're getting the operating levels. Is that fair?

That's right.

That's correct.

Got it. The next question is just looking at in terms of the 60-40 split for existing relative to new customers and your level of confidence that over the next couple of years it's going to go back to a sort of 50-50 split because of an underpinned greater opportunity. So two things over there -- one is can you give us some color as to -- from an end market perspective, what is giving you that confidence. Are you seeing resurging sort of investment plans in the customer base that you already have, or new customers that you've had a long sales cycle with that are shortening?

Second, are you changing the incentive plan for your internal salespeople as the installed customer base keeps increasing, the recurring revenue should be growing at a pretty rapid clip, since your level of penetration is low. So are you continuing to change that incentive plan going forward to drive new sales? Sales to new customers.

A couple things -- relative to the incentive plan, we actually do have a bit of an incentive modifier in place today to drive sales to new customers on the inside sales group to try and get that focused activity and get the new customers in-house. The recurring revenue stream still is not necessarily automatic.

Once you get the product in there, we are still going in and demoing and still going in. It's still a lot of missionary work there, so changing commission structures or anything like that, we're certainly not at a point where we would do that. Whereas you look at, say, a more mature industrial business, once you start getting recurring revenue where the customer picks up the phone and calls in the order, for sure you change commission rates at that point because your account managers aren't spending time on-site to generate the sale. I think we're still a ways off from needing to worry about anything like that.

So I think that's how you ought to look at the commission side there. Now, in terms of the confidence in new customer versus existing, I think some of what you see is just the natural, because the existing customers knew of the technology, may have had already pent-up demand coming out of the downturn, so it was easier for them to pull the trigger quicker than some of the new customers.

I think that's why you see that shift, and similar to '09 it was kind of the same thing, that it was a lot easier for an existing customer to get money approved from a CapEx budget, because they could already show what the ROI was.

We are seeing very, very good demand on the new customer side, and I don't think it's necessarily a shift in the purchasing cycle or the cycle time, the deal times, anything like that. I think we just had a little more focus, probably, on the existing customers the first part of the year.

The back half of the year, like if you look at Q4, the ratio is, I think, 58 existing, 42 new, which is not a dramatic split, but it starts moving in that direction and I would expect to see smaller, incremental steps like that going forward. If the lead counts and demo counts were not supporting that, I'd feel a little bit differently about it, but they do. You've got just as much coming in on the new side as you do on the existing side.

What's interesting about that is the fact that in the December quarter you had a pretty significant uptake of a product that was going out for market where you had a disruptive product when you look at the laser scanner. So would it be fair to assume that the order mix, not the revenue mix, but in the order mix, you're closer to a 50-50?

Without saying I think it's at 50-50, it certainly would be different in the order mix, you're right, because the 60-40, as I described, is sales, and you're correct, we had a huge level of orders of the LS and not nearly as many shipped, which is a big chunk of our backlog. So yes, that's a fair statement.

The last question is just looking at cash flow. You went into the downturn, because of the expense structure you were unprofitable, you had a massive ramp now over the past several quarters and you've built inventory because you have lots of new product introductions. So from this point onwards, the current growth rates you're already talking about, 20% to 25%, which is a moderation from the growth rate you've experienced so far.

So shouldn't the cash flow generation of the Company accelerate quite materially over the next several quarters?

Well, without getting into specific guidance, I think the Company has a history and a growth mode of generating working capital and free cash flow. We have very little CapEx requirements, and it typically runs 2% to 3% of sales. I don't see any reason why that should change over the next few quarters.

But the working capital from current levels, both receivables as well as inventory, there's no reason to believe that those levels will have to grow at the same pace as sales anymore, is that fair?

That's right. That's right.

Got it. Okay, thank you.

Thanks, Ajit.

All right, and ladies and gentlemen, we will go now to the site of Richard Eastman with Robert W. Baird. Please go ahead, your line is open.

Yes, good morning, Keith and Jay.

Hey, Rick.

A couple things -- Jay, could you just talk to maybe a couple items that may or may not have influenced the fourth quarter orders and sales, that being did the Zeiss partnership create any short-term bump in orders? Then also did you see anything that you would feel comfortable identifying as maybe budget flush at the end of the year by customers?

Yes, so on the Zeiss side, and we love our friends at Zeiss, however, that being said -- so I don't want this to be a knock -- yes, we did not see a substantial bump from the Zeiss relationship yet. It is still developing, it's early stage. There's the education of their side on how to present a portable device versus a fixed-base device, et cetera. So I can't say that there'd be anything meaningful in the numbers from that. That growth is all our team.

On the -- sorry, the --

The budget flush.

Oh, on the budget flush, as you know, Q4 always has budget flush, the typical CapEx "use it or lose it." We did not see anything unusual during the fourth quarter in that regard. I would say it's normal budget flush that we would have seen -- quite frankly, we saw it in 2009 and we certainly saw it in the previous years, too.

Okay. Then, Jay, how comfortable with the backlog are you at this point? I think the commentary was you were about $23 million in backlog. Does that get worked down towards what, what would be ideal there, $15 million or $16 million?

Yes, Keith's looking at me -- if I had my way, I'd have substantially more than $23 million backlog going into every quarter. For sure, we'll work some of it down. You've got the ramp-up of the laser scanner, as I've indicated, is a big piece of that. Historically we've gone into any given quarter with, say, four to five weeks of sales in backlog, and that's probably still the right level for us on a normalized basis.

Obviously, that number grows as the sales grow. But assuming -- because everything, even with the LS, again, everything we have is a standard product, and almost everything we have, particularly when you get to the end of the quarter, the order comes in in the morning and it ships in the afternoon.

So on normalized production run rates with the LS at full capacity, you would clear that out a bit and still four to five weeks might be expected going into the future quarters.

Okay.

It might take a quarter or two to get it to that kind of normalized spot.

Yes, so you say we get out to June or so, that maybe our backlog is down to $16 million or $17 million, so we'll be able to draw some out of there in addition to if we think book to bill of 1.0, we work down the inventory, we should pick up some additional sales growth there as well.

Yes, I think you might pick up a little, and you're right -- the book to bill, the one to one is still, I think, probably the right spot for us.

Okay. Then just a question on the gross profit margin by product and service. If I look at where you finished the year and I think about the dynamics on the product side, it sounds like maybe the 3D Focus comes in at a little lower gross margin. Is there any reason that your gross profit margin on the product sales shouldn't hang out at about 65% for the year?

No, I think that's probably a good gross margin for the product side.

Okay, and there's nothing, there's no real dynamic on the service side that should move that around much? Again, 31% or something?

Yes, I think historically, that's been that rate. It's been anywhere from 25% to 35%, but 30% is probably a good middle ground.

That moves around just on the cost experience against those service contracts?

Right, depending on the volume of warranty versus non-warranty, and the volume of units coming back for servicing.

Okay. Then just lastly, Jay, I was maybe just a little bit surprised that your account manager headcount declined sequentially. Not much, but it did. What are we doing there, exactly, in the short term? Are we fine-tuning around or did we lose some people? Because that would be expected to grow in calendar '11 to support $200 million plus of reps, right?

Yes, no, fine-tuning is the right way to do it. I think it was five in total through the course of the quarter.

Yes.

Just some fine-tuning. You would definitely expect to see that number grow a bit, as indicated in 2011, because we do need to add some more to be able to support the ongoing growth there, so fine-tuning is actually probably a pretty good adjective for it.

Okay. All right, very good, thank you.

Thanks, Rick.

(Operator instructions). We will go now to the site of Mark Jordan with Noble Financial for a follow up. Please go ahead, your line is open.

Thank you. One quick question. I know, Jay, that the Company had talked a few years ago about sort of a longer-term business model in terms of various margin goals that you have. Given the fact that a year or two has passed since you've had that discussion and it was kind of not reasonable to talk about it in the midst of a recession, now looking forward, would you review what you think are kind of reasonable targets for your major financial metrics, gross margin against selling, which we talked about, G&A, and sort of op margins over the longer term, not really next year but are a goal for a two to three-year time frame?

I won't say the goal for a two to three-year time frame either, however, I'm not giving you a 10-year number, either. So yes, our goal is still very similar to what we had before, and you're right, once we went into the downturn we had to freeze that for a while. So 20% to 25% on the sales line growth is, I think, still at least the right number for a company like this.

The gross margin, 60% to 65% is still our target. Obviously, as we continue to be disruptive we put pressure on ourselves to do that the right way. That being said, I think we can, and the Focus is a good example of that, that the pure product margin coming out, despite a 60% price increase, is right in the normal wheelhouse of what we've had on our hardware historically.

Selling roughly in the 25% range, G&A 10% or lower, and then R&D, 5% to 7% in that range, give or take. So what that leaves you with is an op margin of 18% to 23% and I think net income of maybe 13% to 16%, in that range. Those are our good targets. They are realistic targets, and without saying a time frame for them would be the only caveat there, obviously. I'm not going to say two to three years, necessarily.

OK. Thank you very much.

It appears we have no more questions at this time.

Very good. Thanks, everybody. We'll speak to you again at the end of the first quarter.

This concludes today's conference. We thank you for your participation and hope that you have a nice day.